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Monday, November 10, 2008

High Finance

The financial problems continue to be of great interest to me so I'm continuing to investigate it in my slow and plodding manner (hey, it's mostly just a hobby for me these days so it gets a low priority). Someday, I may be able to actually draw some solid conclusions about it with some confidence. I'll be sure to report back when and if that happens.

In the meantime, I grow more and more convinced that the government should have just let the financial institutions fail and then compensated by having the Fed pump liquidity into the system at a much higher rate. Don Luskin's recent National Review article identifies problems so far with the bailout which illustrates just how fiendishly difficult it is for a central agency to plan and execute such things:

When the Fed sets the precedent that it will, on a weekend when normal market processes aren’t available, hand over a troubled bank to a competitor at a price well below its market value—below even its value in bankruptcy—there’s no incentive to remain a shareholder at all. Long-term shareholders, who ought to be incentivized to stick with banks that run into difficulty, instead receive the message that they should flee at the first sign of trouble lest they be wiped out by the “rescue.” Stronger banks, sovereign-wealth funds, and other private investors that might profitably help a troubled bank by investing in it learn instead to wait for trouble to boil over into crisis, at which time the Fed will practically give the bank away on a Sunday night.

What’s worse, speculators get the message that they can push banks over the brink by shorting their stocks and spreading rumors, driving share prices so low that it becomes prohibitively costly to raise new capital—assuming anyone would dare invest new capital—and the Fed or some other regulator then has no choice but to step in and put them out of their misery. Such speculative attacks work on any bank the government deems “systemically important”—the new way of saying “too big to fail.”

The other thing I've noticed while investigating the subject, is that the ratio of profits in the financial industry versus all other industries has been steadily rising. Forty years ago (1967), about $1 in $7 of total profits in the United States was made by a firm in the financial industry. Twenty years ago (1987) it was about $1 in $4. Last year (2007), it was almost $1 in $3.

Both the trend (which is pretty smooth) and the direction are worrying to me. The financial industry is an enabler of production, but doesn't actually produce anything of value itself, so to absorb that much of the entire economy's profit incentive seems like a distortion. There may be perfectly good reasons for the trend. For example, the total profit relative to the global economy has probably not increased as much, and the United States does have an oversized share of the global finance business. But still, bailing out the most profitable sector is a bit tough to swallow.


erp said...

You know that old saying, if you're in a hole, stop digging.

Harry Eagar said...

Certainly the intervention has been badly managed. What do you expect with incompetents in charge?

It rather looks as if the mere threat of government support did as much good as was needed to prevent a '33 type collapse.

Even better would have been a New Deal-type intervention of providing liquidity to solvent institutions. Unfortunately, thanks to lack of adult supervision, nobody even now has any idea which ones are solvent.

Unsupervised markets always crash.

It would be interesting to know how much of that smoothly rising curve represented real returns and how much was imaginary. Since the amount of paper in circulation was at least several multiples of even the most optimistic valuation of solid assets, most of it must have been air.

Bret said...

harry eagar wrote: "Certainly the intervention has been badly managed. What do you expect with incompetents in charge?"

My observation is that the vast majority of personnel in government are incompetent (and/or corrupt), I don't expect much. That's why I cringe when government gets involved in anything at all.

I'm glad we're on the same page that the current government is incompetent. That means our only difference of opinion is that I expect the vast majority of governments to be incompetent, while you expect a new FDR-like god to arrive on the scene that will suddenly do an amazing job of regulating everything. Dream on, I guess.

Harry Eagar said...

I am only saying the elected and high politically appointed officials -- who didn't have to meet any standards to get their jobs --are incompetent.

Or, as I put it at Restating the Obvious, 'Heckuva job, Hank.'

I'm surprised you allow yourself to travel on the public roads, seeing as how everybody related to them was incompetent. I bet you pay 1,500 times as much for private water as for untrustworthy public water, too.

aog said...

"I bet you pay 1,500 times as much for private water as for untrustworthy public water"

You mean like all those people who buy bottled water?

Harry Eagar said...


Bret said...

harry eagar wrote: "I'm surprised you allow yourself to travel on the public roads, seeing as how everybody related to them was incompetent."

Indeed, if government employees actually did the work, I'd be pretty scared to drive on the roads. When I see the government crews, I generally see one or two people doing some work, the other eight or ten hanging out talking.

Fortunately, the serious work is done by private contractors. Of course, there's graft and bribes involved, but they are decidedly better than the government workers.

Harry Eagar said...

Bret, are you also Gronker over at Thought Mesh?

'Let's all go to the Trans-Lux and hiss Roosevelt.'